Itaú BBA - No rate hikes this year

Scenario Review - Mexico

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No rate hikes this year

Junho 16, 2015

We now see rate hikes only in 1q16.

• The economy fell 0.6% from February to March, bringing GDP growth to a weak 1.6% qoq/saar in 1Q15 and creating an unfavorable carry-over for 2Q15. There are signs that exports and consumption are recovering. However, as oil output continues to decline sharply, industrial production fell 0.1% between March and April. We have reduced our GDP-growth forecast to 2.4% this year (from 2.6% in our previous scenario). For 2016, we continue to expect a 3.3% growth rate. Higher U.S. growth, the stabilization of oil output and investments related to the structural reforms (especially energy) will drive the economic recovery.  

• As the probability of the Fed’s liftoff in September increases, the peso has depreciated further. However, the depreciation has not been excessive and the currency is performing better than many of its peers. We now expect the exchange rate to end both this year and the next at 15.5 pesos to the dollar, slightly weaker than our previous forecast (15.0 for both years). 

• In May, annual inflation reached its lowest historical point (2.88%) as core inflation remains well below the center of the target (2.33%) and the volatile inflation for non-core food fell sharply. We continue to expect inflation to end both this year and the next at the target center (3%).

• While the central bank continues to pledge that it will closely watch the Fed’s decisions, its tone became somewhat softer recently. Most board members are not willing to back rate hikes before the Fed moves. Up to now, we had been expecting the central bank of Mexico to raise rates in September, together with the Fed. However, considering the tame inflation, the new negative surprises on activity and the fact that the exchange-rate market is “digesting” the Fed’s (likely) liftoff well, we now think that Mexico’s central bank will only start to remove the monetary stimulus in 1Q16, when it will be clear that the economy is gaining traction.    

• In spite of the weaker popularity of the government, the PRI did well in the elections for the lower house of congress. According to the latest figures, the PRI and its allies will maintain a simple majority in Congress, helping the government to pass its 2016 budget proposal and allowing the president to end his term with the support of Congress. 

Weak start to 2Q15

The IGAE (monthly proxy for GDP) declined 0.6% month over month in March, bringing the GDP growth to 1.6% qoq/saar in the 1Q15. The Manufacturing, Construction, Mining and Service sectors all performed poorly in the first quarter of the year. A strong rebound in 2Q15 is unlikely. Apart from the weak carry-over created by March’s IGAE, industrial production fell 0.1% from March to April, due mostly to another sharp contraction in oil production.

On the positive side, manufacturing exports – which usually drive the economic cycles in Mexico – and retail sales are improving at the margin. Although manufacturing exports slowed in 1Q15, consistent with the weak industry readings in the U.S., the March and April figures hint at a recovery. Meanwhile, retail sales were strong in 1Q15 (9.7% qoq/saar). Strong formal employment growth alongside low inflation is boosting the real wage bill, benefitting consumers.

We have reduced our GDP-growth forecast this year to 2.4% (from 2.6% in our previous scenario), but we continue to expect the economy to grow by 3.3% in 2016. The recovery of the U.S. economy will likely lead to higher growth rates ahead. Investments related to the structural reforms (especially the energy reform) will also help the economy next year. In addition, on June 11, Pemex announced the discovery of four new onshore oil fields (which can be explored relatively soon). It estimates production to increase by 200,000 daily barrels for oil.   

The Mexican peso weakens, but over-performs

The rolling-four-quarter current-account deficit stood at 2.0% of GDP in 1Q15 (stable from the 2.0% of GDP reached in 4Q14). In the capital account, foreign direct investment (FDI) came in at USD 7.6 billion for the first quarter of the year, lower than the USD 11.4 billion recorded in 1Q14. Net direct investment (that is, FDI minus Mexican direct investment abroad) stood at USD 4.5 billion in 1Q15 (down from USD 9.2 billion in the same period of last year). As a result, net direct investment was USD 12.9 billion over the past four quarters, still low compared with Mexico’s peers. Foreign portfolio investment amounted to USD 9.1 billion in 1Q15, higher than the USD 8.2 billion in 1Q14, in spite of outflows from local government bonds. Over the last four quarters, foreign portfolio investment was USD 47.4 billion, slightly higher than in 2014 but down from the USD 80 billion peak reached in 2012.

We expect the current-account deficit to be 2.5% of GDP in 2015. In spite of the sharp deterioration of net energy exports, the current-account deficit remains low, due to the weaker exchange rate and slow internal demand growth. Looking forward, we expect FDI to increase in 2016 due to investments related to the structural reforms, while foreign portfolio flows are likely to fall due to the tighter external financial conditions as we approach the policy-tightening cycle in the U.S.

On May 25, the central bank announced the extension (until September 29) of the daily USD 52 million auction mechanism (with no minimum price).

We now expect the exchange rate at 15.5 pesos to the dollar by the end of this year and the next. As the probability of the Fed’s liftoff in September increased, the peso has depreciated further. While the expected FDI flows associated with the structural reforms and the positive impact of the U.S. economic recovery on Mexico’s exports will likely continue to support the peso (the Mexican peso has performed better than many of its peers), the currency is trading consistently weaker than our previous forecast (15.0 both for the end of this year and for the end of the next).  

Inflation reaches its lowest historical point

In May, annual inflation reached its lowest historical point (2.88%), as core inflation remains well below the center of the target (2.33%) and the volatile inflation for non-core food fell sharply. Lower electricity inflation (on an annual basis) also helped to bring inflation down. Inflation for core goods remains very low (2.44%), in spite of the sharp weakening of the Mexican peso, while inflation for core services (2.23%) is also close to the lower bound of the target, as a result of both lower telecom prices and the negative output gap.

We are keeping the inflation forecast at 3%, as the weaker growth that we now expect offsets the impact of the somewhat more depreciated exchange-rate. 

Hikes Postponed

As widely expected, Mexico’s central bank decided to maintain the policy rate at 3% in June. In the press statement announcing the decision, the board highlighted the fragile recovery of the economy and that inflation remains low. The board (or at least most of its members) thinks that the balance of risks to both activity and inflation is unchanged from the previous meeting. Even so, the board continues making it clear that the monetary policy in the U.S. is a key variable for the central bank’s future decisions.

However, in the minutes of the previous monetary policy meeting, the majority of the board members mentioned that a hike before the Fed moves would bring more cost than benefit, hinting that the central bank is unlikely to act in advance of the start of the tightening cycle in the U.S.

We now expect Mexico’s central bank to deliver its first rate hike in 1Q16, months after the Fed’s liftoff (we expect the Fed to hike in September.) Although we acknowledge that the central bank is attaching a lot of weight to the Fed when deciding its own monetary policy, we think that the downside surprises on growth, the further drop in inflation and the fact that the exchange-rate market is not excessively volatile (in spite of the growing probability of rate hikes in the U.S. in September) will likely lead board members to postpone rate hikes. As the economy recovers, the central bank will likely start to gradually remove the monetary stimulus currently in place.  

Our year-end forecasts for the policy rate now stand at 3.0% (from 3.5% previously) and 4.0% (from 4.5%) for 2015 and 2016, respectively.

PRI (and allies) maintains majority in congress

The PRI will remain the largest political force in congress. According to the latest figures regarding the midterm congressional elections that took place in early June, the PRI, along with its allies, will gain 260 seats (of a total of 500) and will maintain simple majority in Congress. The PRD was the biggest loser in the elections, as Morena (the new party of the left-wing leader López Obrador) gained some of its seats. While the structural reforms and its bylaws were already approved, the election results will help the government to introduce the budget cuts needed to preserve the fiscal accounts in an environment of lower oil revenues.

The good performance of the PRI in the elections for the lower house was in spite of the declining popularity of the government of Enrique Peña Nieto. Episodes of violence and conflict-of-interest allegations have damaged the image of the government recently.

On the other hand, discontent could be felt in the elections for local governments. The victory of an independent candidate in the State of Nuevo Leon shows that there are challenges for the traditional political parties in Mexico, in spite of the votes they received for the lower house. This indicates that an independent candidate running for the 2018 presidential elections is a possibility. In addition, the elections show that Lopez Obrador remains an important political figure in Mexico and could gain further support should the reforms fail to enhance economic growth and improve the conditions of the population.


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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